Coase’s theorem: a process of becoming
Steven Medema knows more about the history of Coase’s theorem than many of us know about our spouses.
So whether you are familiar or intimately familiar with the idea, you will probably find some ideas in his article, “Coase’s theorem at sixty” (Journal of Economic Literature, 2020, 58: 4, pp. 1045-1128, subscription required).
In the 1960 article by Ronald Coase, “The problem of the social cost,“ Coase’s “theorem” was not really a theorem, nor does it seem to be the main point of the entirely verbal essay. Coase was working on various regulatory economics issues, which could be summed up as the question of the government’s appropriate response in situations where the market is not performing well. For example, it had been recognized since the 1920s and the work of AC Pigou that certain economic activities could involve “externalities”, where social costs were imposed on others that were not part of the business transaction. Pollution is an obvious example. The common policy prescription was that the government should estimate the value of this additional social cost and then impose a “Pigovian tax” so that the company producing the externality meets the real social cost of its action – in fact, it does not. would not. no longer be able to dump polluting waste into the environment free of charge.
Coase approached the problem of social cost from a different angle. Medema writes:
The article makes three basic points. First, the externalities are reciprocal in nature. Yes, Aactions of B, but to remember A in favor of B imposes costs on A. the economic The problem, Coase pointed out, is avoiding the most serious damage. … Second, if the pricing system operates at no cost and rights are awarded to the relevant resources, agents will negotiate a solution that maximizes the value of output, and this result will be achieved regardless of which party these rights are awarded – the idea that has come to be known as Coase’s Theorem. … In the frictionless world of the welfare economy circa 1960, the outcome of the negotiation shows that Pigouvian remedies are totally useless for effective resolution of externality problems. Third, in the real world of positive transaction costs, all of the coordination mechanisms – markets, business, and government – are expensive and imperfect, meaning there is no path to the optimum. The best we can do is choose among imperfect alternatives … Comparative institutional analysis then becomes the method of choice, and the goal, from an economic point of view, is to select the coordination mechanism that maximizes value of output for the problem under consideration.
Here is how I tried to convey Coase’s “theorem” in an article I wrote about last summer “Are property rights a solution to pollution? (PERC Reports, Summer 2020). In my words:
In a famous example, Coase discussed the hypothetical situation of a railroad running alongside a farmer’s field. The sparks from the train sometimes caused fires in the crops. How to deal with this external cost – a kind of pollution “externality”?
For non-economists, the obvious answer is for the government to pass a law. For example, the government could require the railway company to install spark arrestors on the chimneys of its locomotives, use a different fuel mixture or a new engine, leave a buffer zone next to the terrain, or move the tracks completely. . Alternatively, the government could state that the farmer should build a fence to protect the field, install a sprinkler system, change crops, leave a buffer zone, or maybe even relocate the farm.
Rather than looking at pollution control efforts through the lens of how governments should choose which rule to impose, Coase took an entirely different approach. He stressed that the problem could be reformulated in terms of property rights – in other words, who has what rights? For example, the government could say that the railway company had the right to emit sparks, in which case the farmer would have to find the most profitable way to protect the fields. Alternatively, the government could say that the farmer had the property right not to have sparks among his crops, in which case the railroad would have to come up with an answer – which could include installing spark arresters or other technologies to prevent fires from happening, or even just pay the farmer to put up with boredom.
In Coase’s approach, the question of how to respond to pollution problems such as unwanted railroad sparks did not need to be delegated to a government vote or a committee of experts. In Coase’s view, the pollution problem also did not need to be solved by regulators imposing a Pigouvian tax to account for the imposed “externality”. After all, governments or some other outside group will inevitably have much less detailed and practical information about the range of options available – and how those options might be modified or combined – than railways and farmers. In addition, any choice of specific government regulations will be affected by politics and lobbying. Instead, Coase argued that once property rights are clearly defined, one party or the other would have an incentive to seek the most cost-effective way to reduce this form of “pollution”.
Coase’s work often rejected a common assumption (common both then and today), that direct government actions and mandates are the appropriate responses to market problems. He pointed out that governments often lacked both detailed knowledge of how to solve problems with markets, and also that government acting under political pressure may not have the incentive to solve these problems appropriately. Instead, the role of government could be to set up a system in which economic actors themselves use their detailed private information to make a better decision.
In other classic examples, Coase argued in the 1950s that when it came to allocating spectrum rights, it was better for the government to auction those rights rather than award them through decision-making. administrative. Such auctions would lead private actors to reveal their true preferences, rather than simply deploying their lobbyists. In another article, Coase argued that although eeconomists often cite lighthouses as an example of a country where markets cannot function wellAs a historical fact, many lighthouses were built by the private sector after the government gave them the right to collect tolls.
It may be useful to note that Coase is certainly not making the claim that real world markets are perfect and that private trading will solve all problems. Its prescriptions often involve active government intervention: for example, by setting rules on the liability of railways or farmers to fight sparks, or by organizing auctions for spectrum rights, or by giving builders lighthouses the right to charge tolls. Coase speaks out against “the blackboard economy,” as he later called it, where market problems and government solutions are sketched out in a classroom as a problem solved. Instead, Coase preferred a comparative institutional economy, where the specific details of situations play a central role and therefore it becomes important to think through the details of the information and incentives held by the parties involved.
Coase did not refer to his result as a theorem: instead, this label was awarded by George Stigler a few years later. Medema writes: “[T]Coase’s theorem is neither a prediction nor a testable hypothesis, nor a descriptor nor a policy prescription. It is, and can be, nothing more than a landmark – a generator of predictive, testable, descriptive and political information. “
Medema describes in detail how the Coase outcome unfolds over time, as questions of potential issues, parties involved, information, and incentives have been explored in many contexts – including contexts outside of economics. Here I will end with Medema’s general summary of this process.
Coase’s theorem is, in many ways, one of the most curious results in the history of economic ideas. Its development has been shrouded in bad memories, political controversies and all manner of personal and community confusions and serves as an example of the messy process by which new ideas become scientific knowledge. There is no single statement of Coase’s theorem; there are literally dozens of different statements, many of which are incompatible with others and seem to mark significant deviations from what Coase argued in 1960. …
The theorem has never received a generally accepted formal proof; however, it has been the subject of numerous attempts to “refute” it in a current of analysis and debate that continues today. It has been called “tautology” and “Say’s law of welfare economics” (Calabresi 1968, p. 68, 73), “enlightening lie” (Cooter 1982, p. 28) and even “Religious precept” (Posin 1993, p. 810). Halpin (2007, p. 339) calls the theorem “theoretically degenerate… and ideologically charged”. Usher (1998, p. 3) brings these various charges together, asserting that the theorem is “tautological, inconsistent or erroneous”, the specific verdict being based on the version of the theorem to which one subscribes. …
It is often said that the nature of the underlying assumptions of the theorem makes its domain of direct applicability null; Yet it has been invoked, criticized and applied to questions of legal and economic policy in thousands of journal articles and books on economics and law … as well as in journals covering areas ranging from philosophy (Hale 2008) to literature (Minda 2001) to biology (Frech 1973a). Indeed, Coase’s theorem is perhaps the only economic concept whose use is more extensive outside the economy than within it.